Supreme Court Limits SEC's Ability to Obtain Disgorgement

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On June 6, 2017, a unanimous United States Supreme Court issued the eagerly anticipated ruling in Kokesh v. Securities and Exchange Commission. The Court held that the power of the SEC to take the profit out of violations of the securities laws through the remedy of disgorgement as practiced by the SEC is limited to the five-year period immediately preceding the filing of an enforcement action by the SEC because it operates as a penalty. Specifically, the Court ruled that "[b]ecause disgorgement orders "go beyond compensation, are intended to punish, and label defendants wrongdoers" as a conse­quence of violating public laws, Gabelli, 568 U.S. 442, 451-52 (2013), they represent a penalty and thus fall within the 5-year statute of limitations of §2462." The SEC has long used disgorgement as a basis for securing the return of "ill-gotten gains" or improperly obtained profits earned by wrongdoers as a result of federal securities laws violations, including in instances where the conduct extended beyond five years. The SEC had long taken the position that disgorgement is an "equitable" remedy, not subject to the applicable statute of limitations in 28 U.S.C. §2462, which states: any "action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued [.. . .]." Unlike restitution, which focuses on making the victims of a crime whole, the SEC’s claim had been that disgorgement’s focus is on depriving the wrongdoer of gains it would not have enjoyed but for the illegal conduct, and therefore preserved the status quo but for the violations, making it equitable in nature. Moving forward, in cases involving long-running misconduct, the SEC will either have to use its disgorgement powers in a way that the Court would find to be sufficiently comparable to restitution (i.e., making victims whole) rather than a penalty, or the government will have to rely on the U.S. Department of Justice to use its broad criminal forfeiture powers, which generally allow the seizure of proceeds of criminal acts so long as the charges are brought within the applicable statute of limitations.

The SEC further argued that, in seeking disgorgement, "it act[ed] in the public interest, to remedy harm to the public at large, rather than standing in the shoes of particular injured parties." Kokesh v. SEC, Brief for United States 22. Therefore, the SEC claimed, disgorgement is not intended to punish, but rather to return the wrongdoer to the status quo before the violation. The Supreme Court unanimously rejected that view, noting that as the SEC’s disgorgement orders go beyond compensation of wronged investors, are intended to punish, and label defendants wrongdoers, they are a penalty, subject to the 5 year statute of limitations. The Court observed that "SEC disgorgement sometimes exceeds the profits gained as a result of the violation" and that "SEC disgorgement sometimes is ordered without consideration of a defendant’s expenses that reduced the amount of illegal profit."

The Court did not find that all disgorgement is always a penalty. Despite agreeing with the Eleventh Circuit in limiting the use of disgorgement by the five year statute of limitations, the Court did not agree with the Eleventh Circuit's reasoning in S.E.C. v. Graham, 823 F.3d 1357 (11th Cir. 2016), which held that disgorgement was included within the meaning of "forfeiture." In a carefully crafted opinion, the Court limited the breadth of its ruling, holding that "[d]isgorgement, as it is applied in SEC enforcement proceedings, operates as a penalty under §2462." (emphasis added).

By so limiting its holding, the Court’s opinion in Kokesh does not affect all other disgorgement-related jurisprudence. Thus, the Court has left open a path forward for the SEC to continue to use disgorgement, if it can meet the test set forth in Kokesh. First, the SEC can no longer stand in the shoes of the public at large, but would have to act on behalf of the victims and compensate them from the disgorgement, not the United States Treasury. Moreover, the SEC and the courts will now have to consider both expenses and actual profits for the period beyond the five year statute of limitations if it wishes to reach further back. This is relevant not only for purposes of the application of the statute of limitations to a particular request for disgorgement, but potentially also to the SEC's broader practice of limiting a defendant's ability to offset many expenses, often resulting in the defendant paying more in disgorgement than it actually netted as a result of the violation. Finally, in order to not run afoul of Kokesh's holding, the SEC must not use that disgorgement to "label defendants wrongdoers."

It will be remain to be seen whether the SEC determines to ameliorate its disgorgement practices, by rulemaking or otherwise. Until that time, Kokesh bars the SEC from continuing to administer disgorgement in its present manner for misconduct extending back more than five years.

Also yesterday, in an 8-0 decision in Honeycutt v. U.S. (J. Gorsuch did not participate), the Supreme Court held that liability for criminal forfeiture is limited to the property the defendant actually acquired as a result of the crime. Honeycutt involved 21 U.S.C. § 853 (which applies to drug cases) and it appears that the holding would apply equally to 18 U.S.C. § 982 (the general criminal forfeiture statute) at least with respect to offenses other than money laundering. In the past, courts relied on background principles of conspiracy to impose joint and several liability for forfeiture without regard to each defendant’s respective share of the proceeds. For example, if USD 3 million in illegal proceeds was obtained by a two defendant conspiracy, each defendant was on the hook for USD 3 million in forfeiture. Under Honeycutt, if the mastermind obtained USD 2.9 million, and the co-defendant only actually received USD 100,000, the forfeiture order for the co-defendant could not exceed USD 100,000.

These two cases together have imposed significant limits on previously relatively unconstrained power of the government to seek financial penalties through disgorgement (by the SEC) and criminal forfeiture (by the DOJ).

What To Expect?

For pending investigations, this ruling is very significant. Literally overnight, the SEC is now blocked from seeking countless years of disgorgement from companies and individuals in cases involving dated conduct. Moving forward, we believe the SEC will look to move investigations along quicker and as a result, companies conducting internal investigations may face increasing pressure to make disclosures to the SEC and DOJ sooner than they had in the past. Once an investigation has commenced, we expect that the SEC will be more anxious to rapidly collect evidence, including documents, emails, interviews and testimony. As a corollary to these points, given the significance of disgorgement to the SEC, it will likely be more aggressive in seeking tolling agreements at the outset of an investigation, and that the execution of the tolling agreement will be a strong factor in determining cooperation credit. We do not expect that the SEC will back down completely from asking for disgorgement in most of its enforcement cases. However, in light of the criticism of the Court over how the SEC limits a defendant's ability to offset expenses in calculating disgorgement, it will be worth watching whether the SEC becomes more flexible in allowing expense offsets. We also expect that where the SEC cannot recapture all of the perceived ill-gotten gains through disgorgement, it might seek to do so through civil penalties -- although there are clear limitations on the SEC's ability to arbitrarily seek the imposition of civil penalties as a method of recouping gains foreclosed by Kokesh. In this vein, we expect that there might be more litigation in the coming years over the precise scope of what constitutes a "violation" for purposes of the SEC's ability to seek a per violation civil penalty under Sections 21 and 21A of the Exchange Act.

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